Thursday, April 19, 2012

It has been two years since the new regulations of 403(b)plans went into effect. As a result, on campuses across the country retirement
plan committees were formed, consultants hired, and investment options
examined. Have the new regulations had any effect? Are higher education
retirement plans any better than they were before? The new regulations gave
employers much more responsibility for the design and operation of their plans.
Many plans are now subject to ERISA which assigns plan sponsors fiduciary duty in
managing their plans “prudently.” This means closely monitoring the investment
options offered in the plan, paying attention to costs, and participant
education. How are employers doing? This article takes a brief look.

Cost

The new scrutiny of higher education retirement plans seems
to have brought about only a modest
reduction in cost. Some universities,
for example Cal Tech, did this by adding the low cost mutual fund provider
Vanguard. The reductions in costs are modest because the new provider manages
only a tiny fraction of assets as it slowly accumulates new contributions.
Other schools, for example Harvard University, eliminated the relatively high
cost provider DWS from its menu of investment options. The existing balances
were rolled over into other options. The impact is modest because the DWS’s was
small to begin with.

Given that TIAA-CREF still dominates the higher education retirement market, any significant reduction in cost for higher education plans will
have to be associated with changes at TIAA-CREF. TIAA-CREF’s share among the
largest 30 retirement plans remains above 70 percent. The vast majority of those
assets (around 74%) are in two vehicles: TIAA Traditional fixed annuity and
CREF Stock variable annuity. The expense
ratios on CREF Stock and other variable annuities are the same as they were in
2005. The expense ratios on TIAA-CREF mutual funds, if anything, have gone up.
For example, the hugely popular Large-Cap Value Fund retirement class had the
expense ratio of 0.74 in 2010 compared with 0.48 in 2005.

The good news on the TIAA-CREF front is the introduction of
the institutional class of shares on TIAA-CREF mutual funds in a number of
higher education plans. The institutional share class has an expense ratio
about 20 basis points lower than the retirement class. The TIAA-CREF
institutional class index funds have expense ratios similar to those of
Vanguard’s index funds – an industry leader in low-cost index funds. Unfortunately,
the impact of the new class share is small for two reasons. First, most of the
TIAA-CREF assets are still in its variable and fixed annuities, and the expenses
on those have not changed. The second reason is that only the very largest of
plans are able to offer the institutional class. Even among the largest plans,
only some have the institutional share class. For example, the University of
Pennsylvania, Georgetown, Carnegie Mellon, Indiana University and Cal Tech each have about one billion in TIAA-CREF
assets.Perhaps as a result, they were
able to negotiate the lower cost share class. As of the end of 2010, other large plans such as Cornell
University and the University of Chicago still offered
only the more expensive retirement class shares despite having as much in
TIAA-CREF assets as the schools that now offer the institutional class.
Hopefully, it is only a question of time until the fiduciaries of those plans
successfully push for the lower cost options. How successful smaller plans will
be in pushing for lower costs remains uncertain. It is similarly uncertain how
successful employers will be in encouraging participants to consider shifting
from the higher cost variable annuities to lower cost mutual funds. Still, the introduction
of lower expenses on TIAA-CREF options is a significant step in the right
direction.

Plan design

Despite the new attention to plan design, 403(b) plans remain
far more complex than their 401(k) counterparts. Some observers hoped that the
new regulations would force plans to streamline their design. This has not
happened. The average number of investment options among the largest twelve
403(b) plans is over 160, and no plan has less than 30 investment options. This
stands in sharp contrast to the typical number of investment options in the 401(k) world which is 14. Even IBM’s plan, which is the largest private sector defined
contribution plan in the U.S. with 36 billion in assets and 200 thousand
participants, has only 23 investment options.

There are a number of strikes against plans that offer a large
number of options. First, breaking up assets into many options denies the plans
the economies of scale associated with asset management. Consolidating assets
would probably make more plans eligible for lower cost share class. Second, research
shows that a large number of investment choices lowers participations as
participants become overwhelmed. Certainly, participant education – a point
emphasized in the new regulations – is much more difficult and probably
ineffective when participants face hundreds of funds to choose from. Portfolio
theory says people should be able to invest in various asset classes - it says
nothing about the need to offer choice within each asset class. Therefore,
offering five different large cap value funds seems superfluous. Finally,
monitoring hundreds of investment choices must be costly for the plan sponsor.
At a time where universities and colleges struggle with tight budgets, spending
on investment monitoring seems wrongheaded.

As evidence of the need streamline higher education
retirement plans, consider the plan of Financial Engines - a firm whose
business is to advise plan sponsors and plan participants on defined
contribution plans. Unlike faculty and staff at colleges and universities, the
employees of Financial Engines are skilled investment professionals. Yet, their
plan consists of only 17 index funds – each fund covering a major asset class. Other
financial advisory firms have similarly simple plans. If anyone should be able
to navigate hundreds of investment options it would be the financial
professionals. That their own plan is so simple suggests that there is little
value in offering hundreds of investment options. If financial experts can’t benefit
from in a huge menu of investment options, it is doubtful that the faculty and
staff at a university can.

Overall, the impact of the new regulations on the nature of
higher education plans seems less than dramatic. Yet, there is evidence that universities
are taking a look and making small changes in the right direction.